When to Use the Simple CLV Formula

 

 

There are two customer lifetime value (CLV) formulas provided on this website. This article discusses when it is appropriate to use the simple customer lifetime value formula.

You may also want to refer to the limitations of using this formula and you should also review the article on main customer lifetime value formula. Please note there are also a free Excel spreadsheet template available on this website that allows you to calculate customer lifetime value.

When to use the simple CLV formula

The simple CLV formula is quite appropriate to use when:

  • Retention rates of customers are relatively low (say 50% or less) – which means of most of the customer profit contribution is received in the first few years
  • Profit contributions from customers are relatively flat over time – that is, there is no significant changes in the average customer profitability with time
  • The data inputs to the model are mainly based upon assumptions rather than historical customer data (with the customer lifetime value just being a rough estimate)
  • Only a ballpark customer lifetime value estimate is needed – rather than a precise measure
  • The firm is uninterested or uncomfortable in using discount rates
  • Customers are highly profitable and recover their acquisition costs within the first year

 

How accurate is the simple CLV formula?

In many cases, the simple customer lifetime value formula is quite adequate and will provide a reasonable estimate as compared to the main CLV formula (which is available on the free Excel spreadsheet template on this website).

There are two key differences between the simple CLV and the main CLV formulas are:

  • The simple customer lifetime value formula assumes that all the data inputs (customer revenue/costs and retention rate) remains consistent over time, and
  • The simple CLV formula does not use a discount rate.

Let’s compare the calculations of both CLV formulas using an example as follows:

A firm has an average acquisition cost of $500, average customer annual profit contribution is $800 – which increases by 5% per year, and the firm’s retention rate is 60% (equivalent to 2.5 years average lifetime). In this case, a 10% discount rate is used in the main CLV formula.

Using the simple CLV formula:

  • CLV = $840 (customer profit contribution – see note below) X
  • 2.5 (average customer lifetime in years) –
  • $500 (Customer acquisition cost)
  • CLV = $2,000 – $500 = $1,600

NOTE: In this case, we have used $840 in annual customer profit contribution. While the customer profit starts at $800, it increases by 5% pa – so profit becomes $840 in year 2 and then $882 in year 3, and so on. Because the customer lifetime period s only 2.5 years, the 2nd years’ profit has been used as the approximate average customer profit.

Using the main CLV formula (using the free Excel template):

CLV (before discounting) = $1,660

CLV (after the discount rate) = $1,201

Therefore, a close approximation WITHOUT using a discount rate

As you can see, before the applicable of the discount rate, both CLV figures are very close in value – $1,600, as compared to $1,660 using the template (without using the discount rate).

However, significant differences when USING a discount rate

As you can also see, once the discount rate is applied, there is a significant difference between the two formulas – $1,600 as compared to $1,201.

Therefore, the main customer lifetime value formula (or Excel template) should be used if:

  • The firm normally uses a discount rate
  • The retention rate is quite high (that is, more than 75%)
  • There are significant changes in the customer revenue and/or costs over time